Who Killed the Economy?
Left and right trade blows, but truth lies in the center.
The global financial crisis and the ensuing stresses in government treasuries have revived the archaic rhetoric of the old left wing and the old right wing. Demonizing is going on in many countries, but it is striking in the United States, where radicalism in both the right and left was fading in the 1990s.
In the narrative of the progressive left, the crisis arose out of the unchecked greed in the banking industry, the concentration of wealth that was allowed to build up, and America’s exorbitant privilege to print the money the world uses for international payments. The progressives say they would restore prosperity by correcting fraud and the level of deregulation in banking, slapping steep tax rates on high earners, and demoting the dollar.
We could understand this agenda if it were seen to be aimed at the goal of refueling and protecting the engines of business innovation, resulting in the business investment on which our future prosperity and personal growth depend. But the far left does not make clear what its goals for the economy are and how its agenda will achieve them. Are progressives supposing that if their work was put off for the several years it will take for the economy to recover to the “new normal,” the economy would then be at high risk of another asset-price explosion, malinvestment, and bad loans? Do they suppose that reviving bank lending to business can be achieved by multiplying the number of newly hamstrung banks? Do they suppose that creating new international moneys would end asset-price bubbles?
We don’t have to be progressives to understand that the financial system must undergo serious restructuring. Expertise and judgment in the art of lending for novel ventures must be reacquired. But the progressives ought to stop pretending that bankers have a monopoly on fraud and irresponsibility. Many players in the economy had a role in the housing bubble: those home buyers who made false statements to their creditors, speculators who bought multiple houses with borrowed money on the one-way bet that prices would go still higher, the Congress that deluded households with unsustainable tax cuts, and the Federal Reserve Bank, which kept interest rates unnaturally low for far too long.
In the narrative of the conservative right, the crisis was an inevitable result of undisciplined and wrongheaded expansion of the public sector. The conservatives say they would re-create prosperity and dynamism by cutting a broad range of public spending—possibly using the budgetary savings to cut tax rates. True, some of these conservatives spearheaded the past decade of fiscal irresponsibility. Exhibit A is the trillion-dollar program, enacted in 2002, of “free pills” for retired people on Medicare. Exhibit B is the colossal expenditure on the wars in Iraq and Afghanistan. Is there, despite this hypocrisy, some truth to the claim?
There is no evidence that swollen government caused the speculative bubbles that ruined banks and many households. Among advanced economies, the only bubbles were in the U.S. and Spain, neither of which has a particularly large public sector. What the conservatives may mean is that cutting the public sector is a way—even if not the only way—to a good recovery. But this theme is not backed by the evidence either. Advanced economies with large government purchases of goods and services do not appear to suffer low employment. (Although paychecks are reduced, which discourages labor supply, wealth is comparably reduced in the long run; then paychecks won’t look low and employment is back up.) When public spending in the form of transfer payments makes various services and benefits free of charge, work is discouraged. Yet it is precisely Social Security that legislators fear to cut. And such cuts would create more of the uncertainty that has been hanging over Western economies of late.
It is clear, then, that a policy attack on the classic demons of the far left and far right would not regain the economic dynamism, the economic inclusion, and the degree of stability that appear to have been lost over the past decade or more. There is a crying need for centrist programs: a new network of banks for innovation, a new tax credit to companies for employment of low-wage workers, a restructuring of banks to remove the incentive or the leeway for overborrowing, a cut in the profits tax on new corporations, and broad personal tax increases in economies, such as the U.S., that are vulnerable to a sovereign-debt crisis.
Phelps, winner of the 2006 Nobel Prize in economics, is director of the Center on Capitalism and Society at Columbia University and author of Rewarding Work.